Ukraine’s banking system needs to be put to work serving the national economic interest
In the last few years, the banking sector has gone through enormous transformations that have radically changed its face. And if we look back more than a decade, contrast between the oligarchic banking system of the late Kuchma and early Yushchenko eras, when state banks were atavistic throwbacks to the soviet past while foreign banks were relatively rare and had little impact on the overall system, is even more striking. Local oligarchs have left this scene, as they needed more money to capitalize their own banks with time. And this they could only achieve either through infusions from the government—Privatbank being the most recent example and, before that, Ukrgazbank—or through foreign parent companies, whether European or Russian. Ukraine has finally developed a basic immunity to oligarchic pocket banks and black holes, the textbook example being Privatbank, albeit at a considerable price.
Today, all of Ukraine’s key banks are either state-owned—Privatbank, Oschadny Bank, Ukreximbank and Ukrgazbank—, subsidiaries of European banks—Austria’s Raiffeisen-Aval, Hungary’s OTP Bank, France’s Credit Agricole, and Italy’s Banca Intesa Sanpaolo—, or subsidiaries of Russian banks: Alfa Bank and its recent acquisition, Ukrsotsbank, bought from Italy’s Unicredit, Prominvestbank, the former state industrial bank now owned by Vneshekonombank, and Sberbank Rossii, Russia’s state savings bank. This places Ukraine more and more in a general, Central European post-soviet trend, where most banking and financial institutions have been swallowed up by foreign entities. In Poland, for example, the state-owned share of banks is far higher than locally-owned private ones: 24% to 17%. In Romania, the contrast is far greater, with 8% state-owned banks vs 1% locally privately capitalized ones.
Unlike other Central European countries, however, the share of banks with foreign capital in Ukraine remains considerably smaller than in most post-socialist EU members and remains significantly smaller than the share of state-owned banks. Whereas foreign banks control less than one third of Ukraine’s banking system today, in Poland they control 59%, and in Romania or Czechia it’s up to 90% and more. By contrast, here, the state-owned four major banks constitute 55%.
At the end of February, the Government signed on to the revised Foundations of Strategic Reforms of the State Banking Sector, which was prepared by the Ministry of Finance together with international financial institutions (IFIs). This means eliminating the differences between the Ukrainian banking system and banking systems in Central European countries. Among others, this strategy aims to reduce the state presence in the banking sector by half, to 24% by 2022 through partial or complete sale of state-owned banks, primarily to foreign banks. The expectation is that Ukrgazbank and Privatbank will be completely privatized by 2020 and 2022, either through sale to international strategic investors or through an IPO.
MinFin and the Cabinet are confident that this strategy in the banking sector will make the sector more profitable and more attractive to both foreign and domestic investors, which will, in turn, open access to additional financing at better rates and generate more revenues for the state budget. Restructuring is expected to generate up to UAH 160 billion of added value for the state, including nearly UAH 35bn in the shape of dividends and taxes, and over UAH 85bn from the sale of shares.
The question is, whether prioritizing such reforms in the banking system corresponds to Ukraine’s broader national interest, both economic and political, which should focus firstly on fostering a strong domestic business sector and real economic sovereignty?
Barking up the wrong tree
The measures contained in the Strategy are supposed to testify to the use of state banks to support SMEs. For instance, it states, “Improving corporate management will ensure healthy competitiveness among banks in the public sector, especially in micro, small and medium business.” It further states that Oschadny Bank will “gradually shift the accent in its own operations from large corporate clients, such as state corporations, to mid-sized corporate clients and SMEs,” while Privatbank’s operations—prior to privatization?—“should be directed at building a limited portfolio of loans to legal entities that are known to be low risks, mainly by focusing on lending to SMEs.” Ukreximbank is supposed to continue to mainly focus on financing export and import operations by Ukrainian companies because their options with private commercial banks are fairly limited.
Generally speaking, SMEs tend to depend more on bank loans than big companies do. Still, the results the Strategy anticipates by 2022 do not include the necessary priorities to help shape a powerful national SME sector. When we shift from the declarative portion of the Strategy to clearer indicators, it turns out that even at the level of a strategy there is an obvious bias towards supporting big business first and foremost.
For instance, of the UAH 440bn “additional resources available to lend to the corporate sector” that are supposed to appear as a result of carrying out this Strategy, only about a third, UAH 160bn, is planned to be lent to SMEs. Moreover, an additional UAH 240bn are supposed to be spent on “retail loans to support the consumer needs of Ukrainian households.” In reality, this means stimulating the consumption of mostly imported durable goods, rather than industrial investment and the accumulation of capital by domestic business.
And take Ukreximbank, which is supposed to specialize in financing the export-import operations of Ukrainian companies, but is apparently planning to gradually stop serving clients with liabilities under UAH 100,000, or about US $4,000, and to reduce its branches from 75 to 57. In other words, this is, once again, a distancing from the needs of small businesses, for whom bank loans are critical to support entering foreign markets.
So the Government’s current vision of a strategy for reforming the state-owned portion of the banking system is not oriented towards transforming it into an instrument for implementing much-needed national priorities, such as stimulating the emergence and strengthening of domestic businesses, especially SMEs, to aggressively grow their production volumes and export Ukrainian goods and services. It seems that the banking system itself is the goal, a thing onto itself, and so is maximizing its performance indicators, such as pre-tax profits—which, incidentally should be a bit more than €1bn based on an exchange rate close to what we have today—, the profitability of these financial institutions, which is around 18%, and “UAH 160bn of revenues in the form of dividends, taxes and the sale of stock.”
What’s more, people are once again talking about using the state-owned part of the banking system as a milch cow to patch holes in the state budget meant for current consumption. All this is instead of directing the resources of the state-owned banks, which are now the largest, to spur economic growth by expanding and building up domestic business, especially SMEs.
The importance of lending
Nor does the Strategy provide for effective measures to stop the self-destructive tendency, which seems to be dominating the domestic financial market, of leaching credit resources that should be directed towards manufacturing and other commercial investment for consumers. This includes both through the government withdrawing capital by issuing domestic bonds to cover the budget deficit and through the lack of measures to ameliorate the situation when consumer lending is more profitable and becomes a priority for these banks. With their significant liquidity, these banks are focusing on buying state bonds and, if they do lend, they do so mostly for the consumption of goods that are not even Ukrainian.
This problem needs to be tackled immediately. Either public borrowing on the domestic market should be reduced altogether, or, if this is impossible, the NBU should be directly buying up all domestic bonds in order to leave lending resources on the market. At the same time, both the Government and the National Bank need to find regulatory and fiscal instruments to reduce the profit and appeal of retail lending for banks and to increase its final cost to consumers. This should discourage both groups from a ruinous consumption that neither generates jobs nor support domestic business.
The extremely low level of accumulations and industrial investment that can be seen now cannot provide the necessary stimulus to the economy, let alone an impulse that might ensure the long-term average GDP growth of 10-12% a year that Ukraine critically needs. Only accumulation of capital of over 35% can offer a chance at structural revival and progressive economic growth. In most countries that have demonstrated sharp growth over the last century, it was almost always based on internal financial resources. Foreign investment and lending supported this dynamic after it was already in place.
For this to happen, the banking system has to become primarily an instrument to motivate individuals and businesses to grow their savings, to be responsible about how they invest them, and use them for growth, not consumption. So far, this has always been upside-down in Ukraine. In their pursuit of intermediary profits, bank managers and employees tried by whatever means they could to get people to borrow, often even closing their eyes at the applicant’s unreliability. Meanwhile, the banks themselves became dependent on injections of external resources to feed this destructive habit. Right now this negative trend threatens to emerge in different circumstances, especially if the lion’s share of the banking system ends up in foreign hands. That will make directing state policy at growing domestic business much more complicated than it is now, while the banks are state-owned.
In fact, Ukraine’s state-owned banks have accumulated an enormous portfolio of bad debt, over UAH 400bn worth, or over US $15bn, which constitute 67% of all such debt in the banking system today. More than 90% of this bad debt held by state banks is in the corporate segment and enterprises. But this does not mean that state policy should aim to complicate the terms for lending to business, as happened in the last few years. Experts are already pointing out that, with a slew of complicated requirements that make it harder to issue a loan, Ukraine is already well ahead of other countries in the world, including its main competitors.
On the contrary, the process of growing credits to the manufacturing sector should be unblocked, while the procedures for seizing collateral, declaring bankruptcy and changing owners or selling off company assets to cover debts should be simplified for cases where the borrower cannot or will not service its debt, or shows no readiness to look for a compromise in restructuring that debt. Meanwhile, a slew of bills has been gathering dust in the Verkhovna Rada for years, all of which are intended to increase the level of guarantees for creditors.
In the interests of rapid economic growth and business, credits need to be as cheap as possible and to be issued in large volumes. At the same time, borrowers need to be highly disciplined, and bankruptcy or seizure of assets for those who cannot meet their obligations, need to be highly simplified. Only under these conditions will it be possible to count on steep economic growth, even should there be a massive wave of bankruptcies among less-successful entrepreneurs—something that is quite normal for capitalist economies.
State banks need to become an instrument for stimulating exports of goods and imports of technologies and equipment to spur growth in the SME sector. Cheap credit through state banks is important precisely for small and medium businesses that export their own goods or are at least undertaking projects to expand manufacturing.
Meanwhile, neither in the Cabinet nor in the highest political circles in Ukraine is there a clear plan for directing funds to the productive manufacturing sector of the economy, let alone the consistent implementation of such a plan. There is no strategy for strong credit and financing support for the development of domestic SMEs, which are far more dependent on loans but with whom private commercial banks are not prepared to work at the necessary levels.
Ukraine’s nearly 2 million SMEs continue to be forced to borrow with great difficulty and at usurious interest rates. Meanwhile, their competitors in other countries are able borrow at rates that are several times, if not an order of magnitude, lower. And so only a fairly small portion of Ukraine’s SME sector today is involved in manufacturing.
Even worse, Ukraine’s state banks are actively engaged in programs to promote products from other countries on the domestic market. For instance, Ukreximbank has a series of products aimed at SMEs like “Belarusian imports,” under which the government of Belarus returns part of the loan interest to the borrower, equal to 2/3 of the NBU prime rate, but not more than 8% pa. Such loans are issued for the purchase of farm equipment, transport vehicles or new equipment made in Belarus. Meanwhile, similar products to promote Ukrainian equivalents on the domestic market, let alone on foreign markets, simply don’t exist.